When individuals decide to invest in equity or dive into forex trading, they may see the potential for high returns in situations that require more start-up capital than they possess. In such cases, they may borrow money from a broker or other entity to gain enough capital for their investment plan. The broker, in turn, may ask for some assurance that the investor can pay back the borrowed sum with interest in case the trade goes south.
The sum invested by you, including the collateral provided, is referred to as the margin, and this practice generates a degree of trading power referred to as leverage. Margin trading can generate leverage that can amplify both profits and losses.
While they may seem fairly alike at first, there are several ways to differentiate between them when comparing margin vs. leverage.
Margin
Margin trading is using assets owned by an individual as collateral for soliciting a loan from a broker. The loan received is used to carry out trades.
Margins can generally be defined as the difference between the total value of securities in an individual’s margin account and the loan amount solicited from a broker to carry out the trade.
Buying on margin necessitates opening a margin account with a certain sum as an initial investment/ This sum acts as the collateral and is referred to as the minimum margin.
The sum you invest in the trade and the amount of money to be kept in the margin account as collateral while trading is referred to as the initial and maintenance margins, respectively.
If the sum in the account falls below this value, the broker will force you to deposit more money, pay back the loan using the remaining funds, or liquidate your investment in a margin call practice.
Leverage
While Margin enables an individual to open an equity account or position, leverage, on the other hand, helps you to increase your purchasing power. It involves using different tactics and techniques ultimately focused on fetching better returns.
Say you want to buy the shares of ABC Ltd, currently trading at around Rs 200. Instead of fully paying the amount, one can simply use the leverage. Then the individual investor will pay only part of the amount, say Rs 50. The broker will be paying the rest. Thus, an increase in price by Rs 100 will bring a gain of Rs 250. On the other hand, if you had paid the entire amount, the gain would have been Rs 50 only.
Note that the fall in price will also replicate similar numbers in your loss column. And thus, higher leverage naturally brings in higher risk.
Margin vs Leverage
- Concerning their varying definitions in different contexts, such as equity or forex trading, the main difference between margin trading and leverage is that leverage is most often used to indicate the degree of buying power afforded by taking on debt.
- Another important difference between margin and leverage is that while both practices involve borrowing, margin trading involves using the collateral present in your margin account to borrow money from a broker, which has to be paid back with interest.
The borrowed money, in this case, acts as leverage in allowing you to carry out larger trades.
Both concepts are interrelated. However, it is vital to note that, when comparing margin vs. leverage, margin accounts are not the only means of generating leverage, as this can be done by employing strategies that do not involve margin accounts.
Finally, when identifying the difference between margin and leverage, it is obvious that conservative leverage strategies over long periods tend to reduce risks better. Short-term investments on margins yield good results in markets with high liquidity.
SEBI rules on Margin and leverage
The following are some of the rules that SEBI has laid forward in the recent past concerning trading in Margin and leverage:
- Initially, the traders were required to maintain the directed margins at the end of the day. But SEBI laid new rules wherein four random snapshots will be taken to assess if the Margin was maintained. Failure to hold a minimum Margin on intraday positions will attract a penalty.
- The maximum leverage a broker can offer is restricted as follows,
Maximum leverage = VAR + ELM (min 20% ) or SPAN + Exposure
where VAR – Value at Risk and ELM – Extreme loss Margin
- If you are looking for margin funding, you will have to pay about 30% upfront.
Conclusion:
Margin accounts are commonly used to generate leverage by experienced traders in the securities and forex market. However, novice traders should be warned against leveraging strategies without a concrete understanding of how markets move. They risk losses higher than those they would have encountered if their investments had not been leveraged. The two concepts are closely interrelated, and while it may be initially difficult for some to spot the difference between margin and leverage, their manner of application, the context in which they are applied as well as the restrictions involved in utilizing them are the main points of differentiation when comparing margin vs. leverage.